probing financial statements - strategic finance...the traditional examination of ratios to include...

A p r i l 2 0 0 9 I S T R AT E G IC F I N A N C E 37

FINANCIAL ANALYSIS

By Carlos A. De Mello-e-Souza and Vidya N. Awasthi, CMA, CFM

It’s vitally important to management accountants and senior executives that financial disclosures ade-

quately represent the performance, financial condition, and prospects of a publicly traded company—

especially now, given the certification requirements of the Sarbanes-Oxley Act of 2002.

Confidence in the correctness of those disclosures can be built (or destroyed) by relentlessly asking

questions motivated by standard methods of financial analysis. Moreover, in an age when powerful

spreadsheet and database software has made the financial analysis process much easier and more

robust, senior executives can and should be directly involved in formulating the relevant questions. Our

description of financial analysis techniques is based on developments that expand their scope beyond

the traditional examination of ratios to include issues of accounting quality and security valuation. We

illustrate the methodology by examining three publicly traded retailers: Walmart, Costco, and Target.

P R O B I N G

Financial Statements

I N A

Post-Sarbanes-OxleyWO R LD

Asking the Right Questions Financial statement analysis involves exploring a com-

pany’s numbers in search of explanations for past per-

formance as well as telltale signs about the future. Like a

detective, the analyst is seeking the key to unravel a

mystery or patterns to help organize a vast array of

numbers. The search follows hierarchical lines of com-

mand. The CEO asks the CFO, who summons the con-

troller, who confers with the assistant controller, who

turns to the head of corporate planning, who demands

of a senior analyst: Are investors informed about the

true performance, risks, and opportunities of our com-

pany? What’s the probable margin of error in the num-

bers? Members of the board, the audit committee,

external auditors, and attorneys join the analytical

process. At stake is management’s responsibility for

ensuring that investors have timely and fair access to

reliable information. In this article we’ll discuss the

types of questions that help management acquire confi-

dence in financial disclosures.

According to Benjamin S. Bloom’s Taxonomy of Educa-

tional Objectives: Book 1, Cognitive Domain (Addison

Wesley, New York, 1956), there are six kinds of questions.

In order of increasing complexity, they cover recall, com-

prehension, application, analysis, synthesis, and evalua-

tion. Questions in the last three categories can help

executives verify the quality of financial disclosures:

◆ Questions of analysis target the components and time-

series behavior of the firm’s risk and return metrics;

◆ Questions of synthesis help to integrate a multitude of

facts and perspectives about the company when, for

example, creating pro-forma financial reports; and

◆ Questions of evaluation attempt to resolve differences

of opinion or obtain a ranking of alternative decisions

the company faces.

Sharp queries supported by a comprehensive business

model demonstrate the inquirer’s depth of knowledge

and affect the quality of the answers they elicit. The mere

anticipation of good questions can be a powerful instru-

ment to promote diligence and honesty in preparing

reports at all levels of the organization.

We’ve chosen Walmart to illustrate the approach

because, with the notable exception of 2008, its disap-

pointing stock price performance since 2004 follows four

extraordinarily successful decades during which it rose

from a small chain of variety stores in Rogers, Ark., to

become the largest retailer in the world. We use two of

Walmart’s competitors, Costco and Target, as benchmarks

for comparison.

Kicking the Corporate TiresThe terms “fundamental analysis” and “value-based

investing” are indelibly linked to Benjamin Graham and

David Dodd, authors of Security Analysis (McGraw-Hill,

New York, 1940). Writing in the midst of the devastation

that followed the market crash of 1929, Graham and

Dodd recommended that investors apply the tenets of

economic theory in attempting to identify mispriced

securities. Seven decades later, their recommendation is

no less relevant.

Financial analysis also has been influenced by a num-

ber of more recent developments. Among these are pow-

erful and user-friendly software (spreadsheets, for

example), the hierarchical diagnostic technique popular-

ized by DuPont, models that measure accounting quality

and help predict manipulation (see Messod D. Beneish’s

“The Detection of Earnings Manipulation” in the Sep-

tember/October 1999 issue of Financial Analysts Journal),

and the Edwards-Bell-Ohlson residual income valuation

model (see C.M.C. Lee’s “Accounting Based Valuation:

Impact on Business Practice and Research,” Accounting

Horizons, December 1999).

Financial statements typically are analyzed in four

stages: (1) preliminary data adjustments, (2) ratio analy-

sis, (3) assessment of accounting quality, and (4) valua-

tion. Let’s examine each of these in turn.

Stage One: Data Adjustments. Financial analysts

seek to minimize measurement errors by converting

financial statements to a common set of accounting rules,

recognizing off-balance-sheet items, and distinguishing

between necessary and superfluous assets. Standard

adjustments include separating transitory from recurring

items and distinguishing financing from operating effects.

More-complex adjustments include capitalization of

operating leases, capitalization of R&D expenses, and

consolidation of subsidiaries accounted for under the

“equity method.”

Stage Two: Ratio Analysis. Ratio analysis involves

using ratios of financial statement and market-based

numbers to examine companies over time and to

compare them with each other in terms of profitability,

efficiency, and risk. Are there abrupt changes in relation-

ships, sharp differences with respect to companies in the

same business sector, or numbers that just don’t make

sense? An obvious weakness in ratios is that they presume

linear, stationary-parameter, single-equation models of a

firm. The advantage of ratios lies in their simplicity and

in their power to generate important questions in short

order. A good way to understand the story numerous

38 S T R AT E G IC F I N A N C E I A p r i l 2 0 0 9

FINANCIAL ANALYSIS

ratios have to tell is to organize them according to the

DuPont Model, as follows:

◆ Level 1 disaggregates business value in terms of

growth, risk, and return on equity.

◆ Level 2 explains return on equity as return on assets

plus financial leverage.

◆ Level 3 looks at return on assets as profitability of sales

times asset turnover.

◆ Level 4.a explains profitability of sales via common-size

analysis of income.

◆ Level 4.b explains asset turnover via turnover ratios for

specific assets.

In this article we recommend the advanced version of

the DuPont Model that was published in Equity Valuation

and Analysis with eVal, 2nd Edition (McGraw-Hill/Irwin,

New York, 2004) because of its ability to adjust for varia-

tions in capital structure.

Stage Three: Accounting Quality Analysis.

Accounting quality is associated with how well a compa-

ny conveys its performance and financial position to

investors by means of accounting reports. Since historical

performance is often indicative of prospective earnings,

accounting quality is associated with the degree of link-

age between changes in reported income and changes in

value. Accounting quality is a key concept for executives

responsible for certifying that financial statements are

“fair and true” and for financial analysts and manage-

ment accountants who rely on these numbers to make

recommendations.

There are both qualitative and quantitative approaches

to measuring quality. Qualitative approaches assign scores

to companies based on attributes normally associated with

accounting failures, such as frequent changes in account-

ing methods, ongoing restructuring charges, and changes

in auditors. Quantitative approaches produce measures of

likelihood of manipulation that integrate evidence from

myriad signals contained in accounting reports.

Stage Four: Valuation. Financial forecasts support-

ed by the three prior stages lead to fair value estimates.

Significant gaps between fair values and market prices

hint at important differences between what management

and investors expect. Such differences can cause signifi-

cant losses to investors and may lead to legal action

against the company and its executives. Therefore, a thor-

ough analysis of any gaps between market prices and fair

values is an indispensable step toward relevant, fair, and

transparent disclosures.

Financial Analysis in ActionIn 2007, Walmart was the world’s largest company by sales

(Fortune Global 500) and the world’s largest private-sector

employer with about 1.9 million on its payroll. The com-

pany has been a top-four Fortune 500 company since 1995

and was ranked first from 2002 to 2005 and again in 2007.

Its success is attributed to a few relentlessly implemented

directives such as “always low prices,” investing in little

towns ignored by everyone else, and saturating an area by

spreading out then filling in. Details of this strategy are


50

100

150

200

99 00 01 02 03 04

50

150

250

350

450

550

94 95 96 97 98 9950

100

150

200

04 05 06 07 08 09

Target Walmart Costco

1994 - 1999S&P 500 up 155%

1999 - 2004S&P 500 down 13%

2005 - Jan. 2008S&P 500 up 22%

Figure 1: Comparative Evolution of Stock Prices: Target, Walmart, and Costco(Each series begins at 100% on the left. Source: Standard & Poor’s Research Insight.)

revealed in Made in America: My Story, by Sam Walton

with John Huey (Bantam Books, New York, 1992).

As of Jan. 31, 2007, Walmart operated 4,022 stores in

the United States and 2,757 abroad. Worldwide revenues

grew at a 13% average annual rate from 1998 through

2007, and the proportion of overseas revenues went from

5% in 1996 to 22.4% in 2006. In the analysis that follows,

we use Target (revenues of $63.4 billion in the year ended

Jan. 28, 2008) as a benchmark for the “Stores” segment of

Walmart and Costco (a rival “wholesale club” with rev-

enues of $64.4 billion in the year ended Aug. 28, 2007) as

a benchmark for Sam’s Club. (We label Walmart’s fiscal

year that ended on Jan. 31, 2008, as 2007.)

In 1998, Walmart’s sales were 2.4 times the sales of Cost-

co and Target combined. By 2007, that ratio had increased

to three. But from January 1994 until January 2008, Target

achieved the best total stock price appreciation (+911%),

followed by Costco (+665%) and Walmart (+283%). In the

four-year period ending Jan. 31, 2008 (Figure 1), Costco

led in terms of stock appreciation (+84%), followed by

Target (+46%) and Walmart (-6%). In Walmart’s annual

report of Jan. 31, 2005, Chairman Rob Walton admitted to

being frustrated because “over the last five years, sales have

gone up almost 83% and earnings have grown almost

100%, but our stock price hasn’t moved.” This was partly

because of the poor performance of stock markets as a

whole: During the five years Walton referred to, the S&P

500 fell 13.1%. But that was also a period of slower growth

for Walmart’s domestic operations (see Figure 2) when

momentum was shifting to lower-margin, albeit higher-

turnover, operations: The Walmart Stores to Sam’s Club

quotient of sales growth rates went from 7.2%/2.7%

between January 1994 and December 1998 to 2.3%/4.8%

between January 2004 and January 2008.

In the discussion that follows, we’ll analyze the three

major discounters in terms of accounting rates of return,

profitability, asset productivity (turnover), segment foot-

notes, and accounting quality.

Accounting Rates of Return. Between 1998 and

2007, average returns on equity (ROE) at Walmart and

Target were 22.4% and 19.3%, respectively, while Costco’s

was about 14% (see Table 1). Differences in average

returns on assets (ROA) were smaller: Walmart led with

15% ROA, followed by Target and Costco with about

12% each. The fact that Target maintained the highest

debt-to-equity ratio (0.93 on average), followed by Wal-

mart (0.66) and Costco (0.20), helps explain the ROE

ranking of these companies.

Walmart’s ROE reached a low point of 18.3% in 2001,

recovered to 26% in 2004, but has mostly remained in the

low to mid-20s. The observed volatility in ROE and ROA

stems from transitory components of income, such as

losses from discontinued operations and the impact of

foreign currency translation. Without transitory items,

Walmart’s ROA exceeded Target’s and Costco’s practically

every year since 1998. The loss of 1.7 percentage points in

Walmart’s sustainable ROA between 1998 and 2007 (see

Figure 3) is because of a favorable change in profit mar-

gin (+0.8 ROA points) offset by an unfavorable change in

turnover (-2.4 ROA points).

Profitability. With or without transitory items, Target

(5%) was the leader in terms of average profit margins

from 1998 through 2007, followed by Walmart (4%) and

Costco (2%), which isn’t surprising given the strategies

these companies follow. Common-size analysis shows that

profitability was boosted across the board by downward

trends in cost of merchandise sold as a percentage of sales.

At Walmart, however, higher SG&A (selling, general,

and administrative) expenses meant that total operating

expenses (including depreciation) decreased by only 100


Annual and 12-month moving average

(5)

0

5

10

15

94 95 96 97 98 99 00 01 02 03 04 05 06 07 08

%/year

Figure 2: Growth in U.S. Comparable Store Sales(Source: Walmart’s investor relations site)

FINANCIAL ANALYSIS

basis points. At Costco, the increase in SG&A expenses as

a percentage of sales entirely offset the benefit obtained

from lower proportional costs of merchandise sold, and

total operating expenses ended up increasing by 78 basis

points. Target—benefiting from falling SG&A expenses—

secured a 200-basis-point decrease in total operating

expenses as a percentage of sales. Thus, the net increase in

Walmart’s permanent income between 1998 and 2007 is

largely because of a reduction of 310 basis points in pro-

portional cost of sales counteracted by an increase of 187

basis points in SG&A (see Figure 4). What’s behind these

opposing trends?

Part of the answer—provided in the “management’s

discussion and analysis” (MD&A) section of successive

annual reports—is that Sam’s Club (a lower gross margin

and cheaper SG&A operation relative to sales) has become

a smaller component of Walmart’s worldwide business.

Also, costs of insurance, advertising, utilities, and wages

are increasing. Global sourcing, higher selling prices, and

reductions in inventory shrinkage contributed as well.

Asset Productivity (Turnover). Sales increases

between 1997 and 2007 at Walmart (238%), Costco

(194%), and Target (130%) required large capital invest-

ments that were accompanied by significant declines in

asset turnover (see Table 1). Since 2005, Costco has suc-

ceeded in reversing most of its loss. Walmart’s turnover,


ROE21.7%

ROA15.3%

Fin-Lev6.4%

ato4.28✕

pmargin3.58%

ROE21.3%

ROA13.6%

Fin-Lev7.7%

ato3.61✕

pmargin3.76%

1998 2007

Figure 3: DuPont Analysis for Walmart Based on Sustainable Profitability: 1998-2007

Figure 4: Walmart: Opposing Trends inCost of Sales ( ) and SG&A Expenses ( )

Figure 5: Walmart: Turnover Breakdown, 1998-2007

16

17

18

98 00 02 04 06

sg&a %

74

75

76

77

cos %69

919997

2

167 4

20

40

60

80

100

1998 2001 2005 2007

Long-term assets Net working capital

Day

s of

Sal

es


Table 1: Advanced DuPont Ratios for Target, Walmart, and Costco, 1998-2007(All ratios are expressed as percentages, except for asset turnover and debt/equity.)

YEAR* 98 99 00 01 02 03 04 05 06 07

TARGET

Leverage 6.82 7.23 7.69 7.96 8.22 7.55 10.59 6.08 5.47 5.88

(+) ROA 12.4 13.4 12.9 11.2 10.7 10.1 16.0 11.7 11.7 9.6

(=) ROE 19.2 20.6 20.6 19.2 18.9 17.7 26.6 17.8 17.2 15.5

Profit margin on sales 3.87 4.14 4.17 4.19 5.34 5.14 7.62 5.18 4.87 4.39

(✕) Asset turnover 3.19 3.23 3.10 2.68 2.00 1.97 2.10 2.26 2.40 2.19

(=) ROA 12.4 13.4 12.9 11.2 10.7 10.1 16.0 11.7 11.7 9.6

(–) After-tax cost of debt 5.34 5.17 4.71 3.88 3.66 3.17 3.67 3.25 3.55 2.94

(=) Spread 7.03 8.22 8.20 7.33 7.02 6.96 12.36 8.47 8.15 6.67

(✕) Debt/equity (leverage) .97 .88 .94 1.08 1.17 1.08 .86 .72 .67 .88

Sustainable profit margin 3.96 4.26 4.17 4.19 4.67 4.69 4.83 5.18 5.28 5.13

(✕) Asset turnover 3.19 3.23 3.10 2.68 2.00 1.97 2.10 2.26 2.40 4.39

(=) Sustainable ROA 12.6 13.8 12.9 11.2 9.4 9.2 10.2 11.7 12.7 11.2

WALMART

Leverage 6.36 8.02 7.54 5.75 8.05 8.83 8.98 6.54 7.82 7.72

(+) ROA 15.8 15.1 13.7 12.6 15.6 16.6 17.1 12.2 14.6 14.9

(=) ROE 22.2 23.1 21.2 18.3 23.6 25.4 26.0 18.7 22.4 22.6


(✕) Asset turnover 4.28 3.92 3.77 3.69 3.77 3.80 3.78 3.61 3.62 3.61

(=) ROA 15.8 15.1 13.7 12.6 15.6 16.6 17.1 12.2 14.6 14.9


(=) Spread 11.76 11.51 9.71 8.65 12.68 14.13 14.42 9.54 11.54 11.66

(✕) Debt/equity (leverage) .54 .70 .78 .67 .64 .63 .62 .69 .68 .66


(✕) Asset turnover 4.28 3.92 3.77 3.69 3.77 3.80 3.78 3.61 3.62 3.61

(=) Sustainable ROA 15.3 15.0 13.7 13.2 14.0 14.1 14.6 14.1 13.9 13.6

COSTCO

Leverage 2.87 2.30 2.45 1.66 2.20 2.03 1.91 1.41 .85 1.41

(+) ROA 11.35 10.97 13.83 10.29 11.34 11.05 11.86 13.19 12.72 11.84

(=) ROE 14.2 13.3 16.3 12.0 13.5 13.1 13.8 14.6 13.6 13.3


(✕) Asset turnover 6.64 6.58 6.78 6.34 5.99 5.71 5.71 5.70 6.22 6.27

(=) ROA 11.4 11.0 13.8 10.3 11.3 11.0 11.9 13.2 12.7 11.8


(=) Spread 8.33 8.07 11.07 8.18 9.82 9.34 10.16 11.18 11.51 9.00

(✕) Debt/equity (leverage) .34 .28 .22 .20 .22 .22 .19 .13 .07 .16


(✕) Asset turnover 6.64 6.58 6.78 6.34 5.99 5.71 5.71 5.70 6.22 6.27

(=) Sustainable ROA 13.4 13.0 13.8 11.3 11.1 10.0 10.7 11.7 11.5 10.9

* Time is indicated as Walmart’s fiscal year minus 1. Thus, 07 corresponds to data for the 12-month period ended Jan. 31, 2008.

FINANCIAL ANALYSIS

however, dropped from 4.3 (85 days of sales) in 1998 to

just 3.6 (101 days) in 2007. Still, the loss wasn’t uniformly

distributed: Productivity of working capital has

improved, but that of long-term assets has deteriorated

(see Figure 5).

One likely explanation for the worsening productivity

of long-term assets at Walmart is that newer stores are

increasingly being located where competition is intense

or where sales from an older Walmart store are cannibal-

ized. Another plausible explanation is that venturing into

new geographic areas requires special skills. Absent a

direct explanation for these trends in the annual reports,

we looked for clues in the company’s segment footnotes.

Segment Footnotes. Walmart’s international opera-

tions have generally lagged domestic operations in terms

of profitability and turnover (see Table 2). From 1998

through 2007, international turnover (1.4) averaged less

than half of domestic turnover (3.1). The best level of

international turnover (1.93) was achieved in 1996, a year

of net losses abroad for Walmart. Although the gap

between domestic and international turnover ratios has

steadily decreased since 1999, a dollar invested abroad

still generated only 53% of the sales generated by a dollar

at home in 2007. The company’s lower productivity of

international assets (39% of total assets in 2007), coupled

with the continuing increase in the proportion of total

assets deployed overseas, has dragged worldwide turnover

to 2.4, the lowest point in a decade (see Figure 6).

Walmart’s average international profitability from 1998

through 2007 (4.8%) was also lower than its average

domestic profitability (6%), but overseas profitability has

generally improved since the late 1990s as the company’s

overseas investments have matured, market shares have

expanded, and the company has generally acquired a bet-

ter understanding of each new market. Another measure

that can be derived from the segment footnote is the ratio

of depreciation expense to segment assets. The average

rate of depreciation abroad (2.5%) from 1998 through

2007 was about half the domestic rate (4.6%). We couldn’t

find an obvious explanation for this difference in Wal-

mart’s annual reports.

Summing up, from 2000 through 2007, the profitability

and turnover of Walmart’s international operations

improved significantly. But despite these improvements,

international ROA (8%) remained far below domestic

ROA (17.6%) in 2007. Since ROA is a key driver of share-


Table 2: Walmart’s International and Domestic Segments: Depreciation, Growth, and Return on Assets, 1996-2007

(All values are percentages, except for asset turnover.)

Yeart 96 97 98 99 00 01 02 03 04 05* 06* 07*

INTERNATIONAL

Depreciation rate 2.70 2.30 2.98 2.46 2.20 2.29 2.24 2.46 2.41 2.25 2.69 2.83

Growth in sales 34.8 50.3 62.9 85.6 41.2 10.6 15.0 16.6 18.3 5.3 30.2 17.5

Growth in assets 25.2 156.0 29.0 165.6 1.6 2.3 16.7 14.7 16.3 19.0 14.7 12.6

Profit margin .48 3.49 4.50 3.59 3.46 4.11 4.90 4.98 5.31 5.80 5.53 5.26

Asset turnover (✕) 1.93 1.46 1.45 1.30 1.26 1.36 1.43 1.44 1.48 1.32 1.47 1.53

Return on assets .92 5.10 6.51 4.69 4.35 5.60 7.01 7.19 7.84 7.66 8.15 8.02

DOMESTIC: STORES, SAM’S CLUB, & OTHER

Depreciation rate 3.87 4.06 4.13 4.75 4.73 4.92 4.56 4.60 4.67 4.36 4.42 4.72

Growth in sales 11.1 10.6 11.7 15.3 11.9 14.5 3.6 10.6 9.7 9.1 7.3 6.0

Growth in assets 4.2 3.5 6.5 11.3 16.4 9.2 8.7 12.8 12.9 10.4 9.4 5.1

Profit margin 5.71 5.65 6.13 6.53 6.51 5.88 5.98 5.31 5.32 6.12 6.06 6.07

Asset turnover (✕) 2.78 2.96 3.15 3.33 3.27 3.33 3.16 3.15 3.06 3.00 2.93 2.89

Return on assets 15.8 16.7 19.3 21.7 21.3 19.6 18.9 16.8 16.3 18.3 17.7 17.6

(t) Time is indicated as Walmart’s fiscal year minus 1. Thus, 07 corresponds to data for the 12-month period ended Jan. 31, 2008.

(*) In the annual report for the fiscal year ended Jan. 31, 2008, Walmart changed the measurement of segment operating income and assets ofcontinuing operations. This table reflects the revised numbers for the columns labeled 05, 06, and 07.

holder value, we believe that a discussion about the rea-

sons for this discrepancy and whether it’s likely to endure

are issues that deserve attention in Walmart’s communi-

cations with investors.

Accounting Quality. Income from continuing

operations and operating cash flows for Target, Wal-

mart, and Costco are plotted in Figure 7. The fact that

income doesn’t grow out of proportion to cash flows

suggests that accruals are probably not being used to

inflate earnings.

Messod D. Beneish’s model—linking the probability of

manipulation to changes in gross margin, SG&A expenses

as a percentage of sales, the ratio of depreciation to oper-

ating assets, growth in sales, days of sales in receivables,

leverage, and quality of assets—confirms our initial

assessment that there’s a low probability that Target, Wal-

mart, or Costco engaged in accounting manipulation at

any time from 1999 through 2007.

Valuing Walmart’s Common StockIn terms of sustainable ROA, Walmart outperformed Tar-

get and Costco every year between 1998 and 2007, except

in 2000 when Costco had a very small edge over its two

competitors. And yet in the midst of a strong globaliza-


Figure 6: Comparison of Walmart’s International and Domestic Segments

1

2

3

4

96 98 00 02 04 06

2

4

6

96 98 00 02 04 062

3

4

5

96 98 00 02 04 06

Domestic International Total

TURNOVER PROFITABILITY (% of sales) DEPRECIATION RATE (% of assets)

Revenues expand by 8% between2010 and 2013, by 6% between2014 and 2017, and then by 4%every year beginning in 2018.

Revenues expand by 6% between2010 and 2013, by 5% between2014 and 2017, and then by 4%every year beginning in 2018.

Revenues expand by 4% inperpetuity beginning in 2010.

Revenues remain stagnant in perpetuity beginning in 2010.

RLOW

Turnover (3.6) and operatingexpenses (93.6% of revenues)

remain forever at their 2007 levels.

$81.60

$75.40

$69.80

$40.70

RHIGH

Turnover improves to 4.3, whileoperating expenses increase to93.8% of revenues by 2014.

$95

$87.40

$80.50

$44.50

Table 3: Forecasting Scenarios and Corresponding Fair Values of Walmart’s Stock

Closing stock price on Jan. 31, 2008 = $50.50 per share

Previous 12-month trading range = $42 to $51 per share

Note: Revenues in 2008 and 2009 grow according to consensus market expectations of 6% and 6.9%, respectively.The expected cost of equity capital is 7.7%, based on Value Line’s Feb. 8, 2008, beta of 0.8 and a risk-free interest rate of 3.5%.

Other parameters remain as they were during the year ended Jan. 31, 2008.

GFAST

GSLOW

GSTEADY-STATE

GZERO

FINANCIAL ANALYSIS

tion effort, Walmart has seen a steady erosion in sustain-

able ROA (-1.75 percentage points) as declines in asset

turnover weren’t offset by increases in profitability. In

order to assess the impact of these trends on Walmart’s

stock price, we developed two ROA scenarios (RHIGH and

RLOW) combined with four growth scenarios (GFAST, GSLOW,

GSTEADY-STATE, and GZERO). In each scenario, revenues in

2008 and 2009 (the first two years in the forecasting hori-

zon) grow according to market expectations of 6% and

6.9%, respectively (Reuters.com), and the discount rate

for equity is 7.7%. Other details and fair value estimates

for Jan. 31, 2008, are shown in Table 3.

Fair value with RLOW and above steady-state growth is

$75.40 to $81.60 per share. Fair value with RHIGH at

steady-state is $80.50, which means that the faster growth

rate bought at the expense of lower ROA either detracts

from value or adds insignificantly to it. And this before

any SG&A expense savings or reductions in risk that

could be achieved by slowing the rate of expansion into

new areas.

Assuming we’re insiders (and our analysis therefore

reflects the best current information about Walmart’s

prospects), the analysis above leads to two conclusions

and generates further questions:

1. The market seemed to undervalue Walmart as of

Jan. 31, 2008, in any scenario at or above steady-state

growth. Even assuming sales stagnate beginning in 2010

(GZERO), the price range over the previous 12 months was

barely above fair value! Why is there such a large gap

between fair value and the market’s perception of value?

Would additional disclosures help close this gap?

2. If it were possible to return to Walmart’s higher lev-

els of asset productivity achieved in 1998, the gain in

shareholder value would be approximately 15% to 18%,

independent of growth rates. Current disclosures provide

little if any insight as to whether this result can or can’t be

achieved. Would amending disclosure policy reduce

uncertainty about this issue?

As our example illustrates, a systematic process of

investigation generates important questions of analysis,

synthesis, and evaluation about a company’s financial

reports. The key to acquiring confidence in the data lies in

obtaining plausible, verifiable answers to such questions.

When corporate officers ask questions, they’re likely to

get excellent answers. But this doesn’t mean that their

questions are superfluous. On the contrary: The expecta-

tion of sharp questions posed by an experienced and dili-

gent executive is itself a powerful contributor to

high-quality financial disclosures. Although the develop-

ment of analytical tools (models and software) should be

assigned to specialists, the business acumen needed to

pose good questions—and to interpret the answers—

should be the bread and butter of not only executives but

management accountants, financial analysts, and others

who might be seeking a top managerial position. SF

Carlos A. De Mello-e-Souza, Ph.D., teaches financial

accounting, financial statement analysis, and corporate

valuation at Susquehanna University in Selinsgrove, Pa.

You can reach him at (570) 372-4463 or

[email protected].

Vidya N. Awasthi, CMA, CFM, Ph.D., teaches managerial

accounting, cost accounting, and strategic cost management

at Seattle University. You can reach him at (206) 296-5628

or [email protected].

Note: One of the authors owns no more than $1,500 in Walmart

stock, one of the authors owns $13,668 in Costco stock, and neither

of the authors owns Target stock at the time of publication.


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TARGET WALMART COSTCO

Operating Cash Flows Net Income

Figure 7: Comparison of Operating Cash Flows with Net Income

probing financial statements - strategic finance...the traditional examination of ratios to include...

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